Business.view

Unlikely heroes

Can hedge funds save the world? One pundit thinks so

Feb 16th 2010
| Online extra

“HEDGE funds are fundamentally evil and there is no way to view them in any other light. You're a great guy, but let's not be ridiculous!” This was the response that Jed Emerson received from several erstwhile supporters when he circulated a draft paper claiming that, in at least some circumstances, the activities of hedge funds could be good for society and even for the planet.

Many people might struggle with the idea of hedge funds being a force for good, regarding them as obsessively focused on short-term financial gain regardless of the environmental or social consequences. And Mr Emerson makes an unlikely defender of them, since he is as green in tooth and claw as a capitalist can be. Having first worked organising projects for the homeless, then as one of the first “venture philanthropists”, he made his name with a series of academic papers on what he calls blended value—the notion that the performance of a business should be judged not just by its profitability, but also by its impact on society and the environment.

In the financial crisis, supposedly risky “socially tinged” investments did reasonably well

Soon after Mr Emerson entered the hedge-fund world, it collapsed spectacularly in the financial crisis. But he noticed that supposedly risky “socially tinged” investments, such as those in microfinance bonds, performed reasonably well, turning in positive returns as many hedge funds lost a large chunk of their value. “The financial world as defined by traditional measures of risk and return was rolled on its head,” he says. This prompted Mr Emerson to start probing hedge funds' investment practices, and he was surprised to discover how similar they often were to those of a socially and environmentally driven movement known as sustainable finance. “Not the same, mind you, but quite similar nonetheless,” he says. According to the paper, such sustainable investing accounts for around $2.7 trillion of the $25 trillion invested in America's capital markets. The total invested in hedge funds of every variety in early 2009 was about $1.3 trillion.

Mr Emerson's paper focuses only on that part of the hedge fund-world which employs fundamental long/short strategies, which means researching the long-term prospects of a company and either holding its shares or shorting them accordingly. He does not explore, for example, macro strategies (which bet on, say, movements in exchange rates), let alone “black box” trading strategies that plough through masses of data, seeking patterns that can be exploited.

Trading according to rigorous fundamental research can often mirror sustainable investing, which seeks to profit by taking into account social and environmental factors, he says. Fundamental hedge funds are far more likely than other investors to try to identify a firm's off-balance-sheet exposures, of which a growing proportion may be “environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis”. These types of hedge fund also tend to make relatively little use of leverage, so they are less easily convicted than some of their hedge-fund peers of recklessly gambling with other people's money. Nor do they try to profit by “creating market distortions within the very markets they are investing in”.

Even short-selling could be socially useful

The most interesting section of Mr Emerson's paper is entitled “Shorting as a Social Act?”. It has become fashionable even among mainstream capitalists to condemn the hedge funds that, for example, shorted the shares of banks in the run up to the meltdown in the markets in 2008. There are two sides to this coin, he points out, since shorting can also act as a “canary in a coal mine” to warn the wider market of impending problems and the potential for decreased future performance. Shorting can also help stop market bubbles forming. Used judiciously, to reward attentive investors and alert the broader market to ill-understood risks that a company faces, shorting may indeed be seen as a positive social act, he says.

You can take the man out of the movement, but you can't take the movement out of the man: Mr Emerson now sees the potential for a powerful coalition of hedgies (who short, but only rarely engage in shareholder activism) and investors with a yen for sustainability, such as pension funds (which may press for better management or corporate governance at the firms they invest in, but rarely go in for shorting), in a new movement he calls “short shareholder activism”.

Sceptics may detect a whiff of wishful thinking in all this. But stranger things have happened. Indeed, it is not just hedge funds that are starting to win plaudits from socially minded investors. In private equity, the other main form of “alternative investment”, the venerable firm of Kohlberg, Kravis & Roberts has formed a celebrated partnership, which it expanded last week, with Environmental Defense, a green non-profit organisation, to develop sustainability strategies for the firms it owns. If the private-equity firm once memorably described as the “Barbarians at the Gate” can turn into a tree-hugger, why not hedge funds?